RBC Capital Markets®
Bryan Osmar
Phone: 416 842 6535
Email: bryan.osmar@rbccm .com
Rod Ireland
Phone: 612 9033 3222
Email: Rod.lreland@rbccm .com
September 1, 2011
OTC Derivatives Central Clearing Consultation
Reserve Bank of Australia
GPO Box 3947
Sydney, NSW 200 l
Australia
OTCDConsulta tion@rba.gov. au
Dear Sir/Madam:
Re: Central Clearing of OTC Derivatives in Australia
The purpose of this letter is to respond to the request for submissions outlined in the Council of
Financial Regulators' (Council) discussion paper Central Clearing of OTC Derivatives in
Australia. We appreciate the opportunity to comment on the regulatory developments outlined
by the Council, including the proposal to mandate domestic clearing of Australian dollardenominated interest rate swaps.
In responding to the request, this submission is broken down into the following components:
1.
2.
3.
4.
Background on RBC
Factors to Consider in OTC Derivatives Markets Reforms
Response to Consultation Paper
Further Study
1. Background on RBC
RBC is Canada's largest bank as measured by assets and market capitalization. We are one
ofNorth America' s leading diversified fmancial services companies and provide personal
and commercial banking, wealth management services, insurance, corporate and investment
banking and transaction processing services on a global basis. We employ approximately
79,000 full-time and part-time employees who serve close to 18 million personal, businesses,
public sector and institutional clients through offices in Canada, the U.S., Australia and 55
other countries.
RBC Capital Markets, the Corporate & Investment Banking division ofRBC, provides a
focused set of products and services to institutions, corporations, governments and high net
worth clients around the world. With over 6300 professional and support staff: RBC Capital
Markets operates out of75 offices in 15 countries, including Australia. We work with clients
in over 100 countries around the world to help them raise capital, access markets, mitigate
risk and acquire or dispose of assets. The Australian operations ofRBC Capital Markets
employs approximately 180 professional and support staff providing products and advisory
services to wholesale clients based in Australia, New Zealand and Asia.
In terms of derivatives markets in particular:
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largest in Canada: we are the largest domestic derivatives dealer in the Canadian
market;
trader in major international markets: we have significant derivatives trading
operations in Toronto, London and in New York and are active in a number of
derivatives markets across the globe, including Australia;
hedge internal risk: we utilize derivatives in our own business to manage our risk
portfolio ;
component of client offering: we provide derivatives products and services to our
clients, including buy-side participants such as pension funds and corporate end
users, to hedge their risks and to better manage their businesses.
By virtue of the scope of our operations, we bring a number of perspectives to bear on
derivatives issues that may be of interest for the Collilcil:
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experience with international regulatory developments: we are active in the global
derivatives markets and are therefore involved first-hand with a number of
developing international regulatory developments and trends;
similar regulatory initiatives in Canada: we have had cooperative and ongoing
discussions with public authorities in Canada on derivative market reform issues that
are similar to those faced in Australia;
diversified experience: we have insights into the derivatives market not only in the
capacity of managing our own book, but also in terms of providing risk management
services to a wide range of different clients and end users;
involvement in Australian market: as a foreign bank, we are active in the Australian
markets in serving our clients and therefore have a direct interest in any derivatives
reforn1s that may impact on these markets.
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2. Factors to Consider in Guiding OTC Derivatives Regulatory Reforms
Our comments below on the Council's consultation paper are guided by the following
factors/considerations that we believe are important in assessing the regulation ofOTC
derivatives markets more broadly:
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critical risk management tool: derivatives are a fundamentally important tool for both
fmancial institutions and our clients to minimize risks and to help promote financial
stability;
support the need for reforms: while derivatives were not a cause of the financial
crisis, we recognize and support the need to find ways to improve the functioning of
these markets, including through initiatives such as standardization, transparency,
central party clearing and the use of trading venues;
efficient/effective regulation: any regulatory reforms for the derivatives markets
should be designed to achieve specific, well-defmed public policy objectives and
should be as minimally intrusive and efficient as possible so as to minin1ize market
disruptions for market participants who rely on these products;
flexible/rely on markets: to the extent possible, regulatory reforms should be
principles based - setting out general public policy parameters, while at the same
time leaving as much flexibility as possible for market participants to meet these
obligations through solutions that reflect commercial and economic realities;
sound analysis: reforms should be made on the basis of analytical assessment, with
consideration given to factors such as the availability of other internationally
available venues to achieve public policy goals and an understanding of market
implications if domestic options are adopted;
international harmonization: reforn1s within individual jurisdictions must be
harmonized with international regulatory developments in order to minin1ize the risks
of: regulatory arbitrage; creating unlevel playing fields for market participants;
enacting conflicting or inconsistent regulatory requirements; fragmenting or
disrupting markets; generating unintended consequences for end users of these
products;
managed transition: implementation periods for the reforms must provide for a
reasonable transition period to allow for the complex changes required to market
structures, legal documentation and compliance regimes to be made.
3. Response to Consultation Paper
Consultation Paper Proposals
Consistent with a nun1ber of the principles outlined above, we commend the Council for the
initiative it has undertaken to outline its public policy objectives and proposed regulatory
reforms for the purposes of public consultation before taking any fina l decisions in this area.
This measured approach will be important in helping to ensure that the regulatory refonns
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ultimately enacted in Australia are consistent with international developments and minimize
market disruptions for market users.
In reviewing the details of the paper, we have elected to provide a general response to the
broad direction of the regulatory reform proposals rather than an individualized response to
the specific questions that have been identified. Specifically, the focus of our comments will
be on the concept of mandating domestic clearing for Australian dollar-denominated interest
rate swaps (IRS's) and possibly future rate agreements (FRA 's).
In discussing this option, the Council identified the following considerations in its paper:
1. Any mandatory requirement that a class ofOTC derivatives be centrally cleared
should reflect the following factors:
a. the potential reduction of systemic risk that might result from this move;
b. the viability of central clearing of that product class; and
c. the international harmonisation of clearing requirements across product classes.
As to the benefits of a mandatory requirement, the following factors were noted:
a. having Australian agencies as the primary regulators of a CCP operating in the
domestic market provides superior policy outcomes with respect to regulatory clarity,
transparency and accountability;
b. Australian regulators' capacity to intervene in crisis management scenarios is likely
to be more straightforward with regards to a local CCP; and
c. in enforcing a mandatory clearing requirement, undertaking clearing through
Australian-domiciled CCP 's avoids the prospect of Australian regulation having an
outcome that would require Australian entities to submit to a foreign jurisdiction, if
that was a consequence of directly or indirectly participating in a foreign-domiciled
CCP.
At the same time, the possible negative consequences were also identified:
The agencies recognize that this may have detrimental effects on some market
participants' capacity to net across products that might be cleared through other
CCPs ... .a reduction in cross-cunency or cross-product netting opportunities may
result in increased costs due to additional collateral requirements. The Council
agencies would be concerned if a consequence of this was a serious disruption to the
functioning of domestic markets.
In the section in1mediately below we will expand upon some of the above considerations
identified in the Council's paper.
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Commentary on Mandatory Clearing
We are concerned about the trend towards jurisdictions imposing mandatory regulatory
requirements on particular products:
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critical risk mitigation tool: as noted above, OTC derivatives products are an
important vehicle for entities such as banks, pension funds and corporate end-users to
manage risk;
market refom1s already underway: there are already substantial reforms underway
that will dramatically impact the future ofOTC derivatives markets. These reforms
could increase the cost/pricing and limit access and choice, which could have broader
negative implications on risk management, fmancial stability and broader economic
growth over time, e.g.:
o higher capital costs/de leveraging of markets: the imposition of higher capital
levels will almost certainly contribute to the deleveraging ofOTC derivatives
market globally as the Basel III capital rules (in effect January l , 2013 for
international implementation, November 1, 2012 for Canadian banks) impose
a significant increase in capital against OTC counterparty derivatives
exposures These capital increases can be expected to have a significant
dampening impact on OTC derivatives risk intermediation with some
derivatives products classes relatively more affected than others;
o deglobalization of the OTC derivatives markets: historically, OTC
derivatives markets have been characterized by a number of efficient features
such as flexible bi-lateral relationships, principles-based regulation and global
booking points and trading activity. Regulatory developments across a
number of jurisdictions, however, including in the United States under DoddFrank, will contribute to the fragmentation ofOTC derivatives markets as
transaction booking moves into regional subsidiaries and away from global
booking points. This will present significant organization design challenges
for many market participants and introduce extra-territoriality concerns across
jurisdictions;
o increased legal and compliance complexity and regulatory costs: the
legislative and regulatory initiatives currently underway, including through
vehicles such as Dodd-Frank in the US, will trigger the need for widespread
multi-party execution, clearing and margin segregation agreements between
dealers, clients and CCPs. Existing bilateral OTC derivatives documentation
will also need to be renegotiated and/or amended . The possibility of legal
and documentation gridlock impacting market participants is a real concern.
The costs related to these changes, particularly in areas such as mandated
margin segregation in a clearing market as compared to a rehypothecated
OTC bilateral market, could be substantial;
o global market consolidation: the consolidation underway globally with
exchange and clearing houses likely reflects the anticipation of future
revenues migration from the OTC derivatives space into central execution
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and clearing venues. Whatever the motive, the restructuring underway in the
market infrastructure space will, at least in the short teim, complicate clearing
venue risk assessment and decision making around clearing venue selection.
Taken together, the above changes that are already in progress will culminate in dramatic
changes to the OTC derivatives markets that will inevitably have consequences for market
participants, including both dealers and users of derivatives markets. Our concern is that the
move towards mandated domestic clearing across a number of jurisdictions will only serve to
exacerbate the negative consequences noted above. Specifically, there is a concern that the
national jurisdiction biased approach relating to mandatory OTC clearing obligations will
have a number of negative implications:
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market fragmentation: accentuating the pressure towards the fragmentation and deglobalization ofOTC derivatives markets as transaction booking moves into regional
subsidiaries and away from global booking points;
legal complexity: creation of significant potential conflicts and organizational design
challenges for many market participants arising from the extra-territorial application
oflaws;
negative market impacts: loss of significant efficiencies and netting opportunities as
markets become increasingly fragmented into narrow mandated product classes; risk
that markets for domestic products may be too smalVilliquid to warrant/support a
domestic CCP, creating disruptions/dislocation in the markets for these products;
competitiveness concerns for dealers: risk that anti-competitive concerns could arise
as players subject to local mandated clearing rules are no longer in a position to
compete or participate in global derivatives markets against larger players who may
not be subject to the domestic clearing requirements and would have the flexibility to
provide OTC derivative clearing and execution services on a global scale for their
clients;
in1plications for end-users: as markets fragment, costs could increase and access and
choice may be more limited. Hedging/risk management could become more costly
and complex contributing to reduced stability and negative broader economic
consequences.
Positioning these concerns within a broader international context, you may be aware that in a
letter dated July 5, 2011, lSDA and a number of other associations highlighted the following
issues for regulators considering reforms in this area:
In September 2009, leaders of the G20 undertook to strengthen the international
fmancial regulatory system. Shared G20 commitments included measures to ensure
stricter rules on transparency, capital, counterparty risk (through clearing and other
operational commitments) and trading of de1ivatives contracts. Considerable
progress has been made on these commitments by G20 members, and it is clear that
G20 leaders will successfully deliver them.
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Importantly, understanding the global nature oftoday's financial markets, the 020
also undertook to "take action at the national and international level to raise standards
together so that our national authorities implement global standards consistently in a
way that ensures a level playing field and avoids fragmentation of markets,
protectionism, and regula tory arbitrage."
The associations signing this letter are concerned that regulation in different 020
jurisdictions may be creating conditions which will lead to the above-mentioned
harmful outcomes, ultimately decreasing the ability of global regulators to effectively
regulate an increasingly global capital marketplace ....
Extra-territorial application of one nation's laws to another nation's market and firms
is a fundamental concern in a global market like derivatives, where it is common for
counterparties based in different parts of the world to transact with each other.
Regulators should seek to agree on the standards for equivalence or recognition for
CCPs in each others' jurisdiction- to avoid such ambiguity and to give CCPs and
regulators the opportunity to meet the standards (also giving market participants the
opportunity to prepare for compliance and to transition to a cleared environment for
their trading activities) . Equivalence is critical for rules on clearing as conflicting
clearing requirements would be impossible to comply with if the rules of each of two
differentjmisdictions require a trade to be cleared in its jurisdiction.
Based on the above, we are concerned that the proliferation of mandatory domestic clearing
requirements in a number of different jurisdictions will create the risk of significant market
fragmentation, disruptions in markets and competitive dislocation that will have important
negative consequences for not only dealers but for end users such as pension funds and
corporations seeking to manage their risk through OTC derivatives products. Prices could
increase, choice could decline and the markets could become much more concentrated and
complex from a trading perspective.
4. Further Study
As suggested above, we are concerned that the existing and prospective regulatory
developments will have significant negative consequences for market participants and that
these will only be exacerbated through the imposition of mandatory domestic clearing
requirements. Having said that, however, it is clear that the extent of these concerns will
vary by jurisdiction and by product and that further analysis would be required to better
understand the specific implications of the proposal to mandate domestic clearing for
Australian dollar-denominated interest rate swaps.
In this regard, the Council may want to consider Canadian developments on this issue. In
particular, recognizing the potential risks associated with a similar proposal for mandated
clearing of Canadian-dollar-denominated interest rate swaps, industry participants are
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working closely with public authorities on a modeling initiative to better understand the
possible consequences of a mandatory domestic clearing requirement for these products.
As part of this analysis, detailed scenarios are being developed on the following:
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the consequences of alternative OTC derivative clearing scenarios, assuming:
1) various combinations of mandated vs. exempt Canadian counterparty
participations;
2) various combinations of Canadian dollar products inclusion; and
3) alterative levels of foreign participation in the Canadian CCP
the pricing, funding and capital implications of margin segregation vs.
rehypothecation made under alternative scenarios for direct and third party OTC
derivatives clearing;
the potential for the Canadian CCP participants to achieve cross margining benefits
with Canada future and repo clearing venues;
the implications of increased Basel III capital requirements on cleared and noncleared derivatives products, pricing, transfer of back books, and implications for
foreign participation;
the possible incentives that could be considered to attract foreign market players to
participate in a domestic clearing option, with a particular focus on the implications
of mandating domestic market participants to use just one clearing venue when other
market competitors have access to alternative offshore CCPs.
The objective of this analysis will be to attempt to provide an empirical understanding on the
following:
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public policy concerns: what is the extent of the systemic risk posed by the product
in question? (i.e. while the notional values could be substantial, once considemtions
such as netting and the extent of existing clearing is taken into account, the net
exposures may be quite low); would the negative market impacts outweigh any of the
benefits to be gained in reducing risk?;
market impacts/disruptions: what would be the impact of imposing a mandated
clearing requirement on domestic dollar-denominated interest rate swaps? (e.g. is
there sufficient liquidity in the market to sustain a domestic clearing venue?; what
would be the impact on pricing/access/structure of the market for these products?;
what are the impacts on margin requirements; what are the opportunities/limitations
on cross-margining potential; what are the implications for cross-currency swaps?;
implications for end users: would pricing increase?; would there be restricted access
to products/suppliers?; would there be an incentive to use foreign dealers/markets?;
implications for financial institutions/dealers: if domestic dealers are mandated to use
the domestic clearing venue while their competitors could continue to use the venue
of their choice, would the domestic dealers be able to compete?
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The overriding goal of this work is to provide a concrete modeVdata set to verify the
implications regarding mandated domestic clearing. We believe that this information will be
critically important in helping to inform the policy approach and regulatory options that
Canada should consider on a going forward basis.
Given the similarities in the Australian approach to the options under consideration in
Canada, the Council may want to consider undertaking a similar scenario modeling exercise.
To facilitate this work, we would note that the analytical assessment we have undertaken in
Canada is expected to be completed by October at which time we would be pleased to share
the results with the Council. This type of analysis could be helpful in informing the specific
responses outlined in the Council' s paper.
While the above analytical work would take some time to complete, we would note that
there seems to be some recognition in a number of jurisdictions, including the US and
Europe, that it is better to take the time to get things right rather than to adhere to tight
timdiues that wulJ create significant market disruptions. A related benefit of a measured
approach is that it would allow time for international market and regulatory reforms to
progress further which may provide further guidance on the shape of the scope of changes
that may ultimately be required in markets such as Canada and Australia. As an example,
international precedents could develop on the use of vehicles such as trade repositories
and regulatory memoranda of understanding among regulators on issues such as clearing
that could respond to domestic public policy concerns while at the same time promoting
the consistency and international harmonization needed to ensure the ongoing stable
functioning of these markets.
In closing, we would note once again tl1at we appreciate the opportunity to comment on
these issues and would be pleased to follow up if you have any questions or comments on
the foregoing.
Sincerely,
Bryan Osmar
Head, Market Infrastructure
RBC Capital Markets
Rod Ireland
Head, Global Markets Australia
RBC Capital Markets
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